Memorandum submitted by David Morgan
1. PREVIOUS TISC
RECOMMENDATIONS AND
THEIR IMPLEMENTATION
OVER THE
PREVIOUS FOUR
YEARS
1.1 The profit assessment method of calculating
rent should be carried out in accordance with national accounting
standards and with knowledge, prudence and diligence (144).
1.1.1 A significant proportion of my professional
involvement of licensed and leisure property over the last 34
years, has been in respect of issues concerning rent review. As
a Fellow of the Royal Institution of Chartered Surveyors, I regularly
meet similarly qualified individuals acting specifically under
the instructions of Pubcos that form the vast majority of the
freeholders of the premises with which I am involved. The method
of valuation adopted nationwide and by all specialist licensed
property valuers, is that of the profits test in the assessment
of open market rental, either upon review or lease renewal.
1.1.2 The objective of the profits test
is to effectively replicate the Trading and Profit and Loss Account
of the hypothetical lessee in occupation with the exception of
the input cost of the rent, thereby achieving a surplus or divisible
balance which is split evenly between landlord and tenant as rent
and tenantable remuneration. Rent review clause disregards are
also infused which, to a degree, can make the valuation artificial
if properly assimilated.
1.1.3 The key to the profits test is the
first input which is a genuine assessment of fair maintainable
trade that should be achieved by a reasonably competent operator,
having adequate market knowledge and operational skills and allowing
for the expectation of consistency over the years until the next
rent review, which would enable a test of genuine profitability
to be made other than in only the first year.
1.1.4 Having established that initial level,
appropriate gross profit margins are then assessed based upon
the specific on site circumstance of the outlet concerned. There
is considerable variation in respect of gross profit margins,
dependant upon immediate and direct competition. All items of
income are analysed, namely drink, food, accommodation (if any),
amusement machines and any other sources of income.
1.1.5 From the assessed gross profit, a
deduction is then made for establishment overhead expenditure
excluding rent. Allowance should also be made for interest on
working capital and for the notional acquisition of the inventory
at in situ value, allowing for interest and capital being repaid
monthly in arrears, usually over a maximum period of 10 years.
1.1.6 The assessment of fair maintainable
trade must include the relevant disregards set out in the rent
review clause of the lease of the premises and in accordance with
the Landlord and Tenant Act 1954 and subsequent legislation. (See
2. below).
1.1.7 It is accepted that the various input
factors are a matter of personal/professional interpretation and
should as closely as possible, mirror relevant on site circumstance.
It is acknowledged that some leases require the tenant in occupation
to produce annual accounts and copies of VAT returns. In those
instances, it has to be considered that the freeholder/landlord
should have an accurate insight into the detail of the trading
operations of the premises. Tenants in occupation can also volunteer
their accounts, should they feel so minded.
1.1.8 The calculation system, however, is
open to abuse which very often occurs in the justification of
a significant increase in rental upon either review or lease renewal
by predicating "potential trade".
1.1.9 As a result of my personal day-to-day
involvement in rent review, experience indicates that the vast
majority of initial rent assessments over-estimate fair maintainable
trade, over-estimate gross profit margins and under-estimate establishment
overhead expenditure. The resultant is always a significantly
inflated divisible balance which if split evenly between parties,
produces a similarly inflated rent justification.
1.1.10 There can be in excess of 35 input
factors in a profits rent calculation, all of which are accepted
as being capable of having variation. National accounting standards
require the detail of these input factors to be revealed much
in the same way as a detailed Trading and Profit & Loss Account
is prepared for taxation purposes.
1.1.11 I have never found any such detail
being included in the calculation exercise by the representatives
of the Pubcos unless and if, third party referral is the only
method of resolution of the rent review.
1.1.12 I thus conclude that Recommendation
144 is not being adopted by any of the Chartered Surveyors as
Pubco representatives that I regularly meet in the open market.
1.2 A Comprehensive breakdown of how the
rent is calculated should encompass and reveal the whole detail
of the profit assessment and how the lease conditions have been
interpreted (145).
1.2.1 The first line of direct relationship
between a Pubco and the supply tied lessee, is that of the Business
Development Manager or Business Relationship Manager (BDM/BRM).
In the days of brewery companies, these same individuals were
known as "Divisional Managers" (DMs). None of the individuals
concerned are Chartered Surveyors and some, but certainly not
all, may have had direct trade experience as previous licensees.
1.2.2 Rent reviews are generally perceived
as adversarial. Starting off with this basic premise, the field
of negotiation is widened considerably in that the basic viewpoint
is that the Pubco (effectively a property company rather than
a brewer), seeks to maximize rental income and enhance shareholder
value. The tenant seeks to minimize any form of rent increase
and thus ensure maximum operational profitability. Thus from the
outset, the objectives of both parties are at opposite ends of
a particular spectrum.
1.2.3 I have not been involved in any initial
exploratory discussions between tenant and BDM/BRM. I would not
expect to be involved in these discussions as it is a natural
aspiration of any tenant that he/she can successfully resolve
a rent review negotiation. The Pubco representative approaches
the situation with three aspirations:
— a sky-high rent demand that only
an idiot might accept, but you never know;
— a middle ground rent review that
has been authorized by his superiors as a settlement level that
can be justified internally; and
— an ultimately lowest level settlement
that is either accepted after significant negotiation processes
have been exhausted, or by third party referral (arbitration/independent
expert).
1.2.4 There are thus three different levels
of rental and initially obviously the highest is the only one
that is quoted. Thus the process is adversarial.
1.2.5 Anecdotal evidence leads me to conclude
that there is never any paper justification for the first aspirational
level of rental. If pressed and indeed it is accepted that a large
number of tenants do not understand that they can request this
information, the Pubco representative will never produce the justification
for the first level of rental and just inform the tenant that
the company has calculated the rent with their best interests
at heart and they should just accept it, otherwise arbitration
will cost thousands of pounds.
1.2.6 If the initial negotiations are unsuccessful
in producing an agreement, an "offer to settle" is then
made with great reluctance, which is the second level of rental.
Again, no paperwork is ever produced in the justification of that
level unless specifically requested. The "theatre" of
the reverse side of a laptop computer is always used as a "prop"
by way of justification.
1.2.7 Recent examples of ongoing rent negotiations
in 2008 have produced exact replicas of the above scenario. They
include:
— The Park Royal, Exeter—Enterprise
Inns;
— The Filly Inn, Lymington—Punch;
— The Colliers Arms, Skewen—Enterprise
Inns;
— The Black Horse, Chippenham—Enterprise
Inns;
— The Sir Robert Peel, Kingston-on-Thames—Punch;
— The George, Wedmore—Admiral
Taverns; and
— The Papermaker's Arms, Dartford—Wellington
Pub Co.
1.2.8 As a sample of the ongoing negotiations
that occur in every single instance, I then formally requested
by letter, the provision of a detailed justification of the rental
assessment. In every instance, the justification was on an abbreviated
form showing, for example, total sales ex rather than breaking
down the sales into their constituent elements.
1.2.9 Expenses are always shown as a single
aggregate sum and are never broken down into individual input
items. There is always a complete lack of detail as to how the
summary income and expenses were achieved and until third party
representation occurs, items such as working capital, ullage,
wastage, purchase of the inventory and especially rent review
disregards, are all ignored.
1.2.10 A particular area of concern is the
interpretation of lease clauses regarding rent review disregards.
The three items of concern are:
— The disregard of tenantable goodwill.
— The disregard of the fact that the
tenant has been in occupation.
— The disregard of structural works
undertaken by the tenant at the tenant's expense with landlord's
approval.
1.2.11 I have never encountered a rent review
negotiation that initially ever accepted that either of the first
two items as outlined above should even be considered. In respect
of the third item, a curious situation exists that is exploited
by the Pubcos, should the situation arise. I deal with the issue
of structural alterations in a separate heading below.
1.3 The detailed profit assessment should
form an addendum to leases to ensure transparency for any subsequent
review or assignment (145).
1.3.1 Since the issuance of the voluntary
regulations by the TISC in 2004, there has been no discernable
transparency in the detailed profit assessment in the many hundreds
of rent review situations in which I have been personally involved.
There has been no attempt by any Pubco to be transparent in the
calculations even when forced to reveal this information. As outlined
above, the very last thing that a BDM/BRM indicates to the tenant,
is the method of calculation of the first (and highest) levels
of rent in what again must be repeated, is an adversarial confrontation.
1.4 The tied tenant should not be financially
worse off than if they were free of tie (133).
1.4.1 There is no obligation that a Chartered
Surveyor should have to follow this method of logic. In the regulations
that have been published in the RICS Valuation Standards (Jan
2008) and associated specific detailing as a result of the Trade
Related Valuation Group and the publication "The Capital
and Rental Valuation of Restaurants, Bars, Public Houses and Nightclubs
in England, Wales and Scotland" (2003), there is no specific
guidance as to how to formulate the obligation of equality. As
a direct result of the lack of implementation either by the Pubcos
or the RICS of the directive 133, there is a uniform misunderstanding
within the body of Chartered Surveyors serving the Licensed Valuation
market as to how the assessment of rent review should be undertaken
in accordance with the TISC recommendations.
1.4.2 There has been minimal attempt to
differentiate between supply tied and supply free in the profits
test calculation by the valuers acting for Pubcos. However, the
prime source of comparable evidence has always been other supply
tied public houses which has meant that there has been no reference
or obligation to equate supply tie with supply free. From a personal
standpoint, I have not attempted to force the issue in the absence
of RICS guidance.
1.4.3 Rent reviews are often undertaken
with the benefit of selected comparables. The Pubco, however,
has a manifestly unfair advantage as it has access to all of the
comparables of its own estate, either locally or regionally. There
is absolutely no opportunity for a tenant to have access to any
of this database and from my personal experience it is never offered
for the assistance of the tenant, other than to cherry-pick the
very highest examples to prove a rent increase. In almost every
instance, the comparators are of other tied houses with no direct
comparisons to supply free leaseholds as in reality, these outlets
are not contained within a supply tied Pubcos estate.
1.4.4 From my direct experience, no Pubco
valuers attempt to exercise the directive 133 in its correct understanding.
1.5 Removal of upwards only rent reviews
(151).
1.5.1 Both Punch Taverns and Enterprise
Inns have openly declared that in new leases, they would instigate
upwards and downwards rent reviews. In this respect, new leases
issued by both companies do indicate that at the fifth year on
a quinquennial rent review basis, reviews will be undertaken on
an upwards and downwards basis.
1.5.2 However, I consider that a rent review
actually means a proposed change in rent when the existing rent
is reviewed by whatever means at whatever interval. Thus annual
increases in accordance with the uplift of the Retail Prices Index
(approximately 4.25% p.a. and rising) in the intervening five
individual years prior to a quinquennial rent review, actually
mean that the rent is being increased on a compounded basis by
approximately 25% upwards only. It appears that this indexation
goes completely against the core issue that every rent review
should be upwards and downwards.
1.5.3 Examples of this practice of upwards
only reviews, exist as follows:
— In the last four years, both the
Punch Growth Lease and the Enterprise Inns Retail Partnership
Agreement state that there shall be annual rent increases in accordance
with the Retail Prices Index. In all of its 80 or so years of
established use, the Retail Prices Index has never seen anything
other than upwards movement.
— As an example of the current practice,
advertisements issued in July 2008 by Fleurets advertising new
leases, indicated throughout all of the prospective lease documents
under the heading "Tenure" "the property is available
on a new Enterprise Inns lease for a term of between five and
25 years with a tie for drinks products. The rent will be stepped
during the first year to a passing rent of £... pa thereafter
which is subject to annual RPI increases and formal rent review
after 5 years. Machine income is shared between Enterprise and
the retailer".
1.5.4 In the Enterprise Inns Retail Partnership
Agreement which is now common throughout the entire estate and
is the basis of lease agreements in the generality, Schedule 3
contained within that agreement, deals with rent reviews. Schedule
3, Section 1"Annual Reviews" states in paragraph 1.1
that the rent will be increased by the same percentage as the
increase in the Retail Prices Index over the 12 month period since
the previous annual review date. In paragraph 1.3, it clearly
states: "if the index has decreased during the relevant 12
month period, the rent will remain the same". Quite simply,
the rent is not capable of a downwards review until the fifth
year.
1.5.5 Schedule 3, paragraph 2.1 does not
actually state in simplicity that the rent should be reviewed
upwards and downwards. The paragraph actually states: "On
each rent review date the rent will be reviewed to the market
rent at that date". There is then reference to a hoped-for
amicable negotiation and in the absence of that amicable settlement,
reference to an independent surveyor. Having set out the detail
of the reference to the independent surveyor, paragraph 2.5 states:
"The reviewed rent may be higher or lower than the previous
rent". Thus the clear inference is that if an amicable agreement
is not reached, the only method of establishing market rent and
thus a downwards rent review, is by recourse to third party or
an independent surveyor.
1.5.6 Even if the rental is obviously deemed
to be reduced, it is the exception and certainly not the rule
that a nil increase will be proposed, rather than a genuine long
term (five year) reduction.
1.5.7 It is appreciated that Enterprise
Inns and Punch Taverns offer concessionary rentals. This should
not be confused with a permanent downwards rent review cycle as
a concessionary rent is exactly what it means, ie a short term
alleviation of an existing high rent and a return back to that
rent after a limited period of time. Certain circumstances also
dictate that the concessionary rent must be repaid.
1.5.8 Concessionary rent opportunities are
sometimes offered under extremely constraining circumstances of
ultra confidentiality and on the basis of a sacrifice of any supply
free advantages which would then disappear for ever and the implementing
of RPI indexation where previously it did not exist and further
machine ties. Concessionary rents are only ever offered with considerable
constraining further ties and obligations.
1.6 Removal oF AWP tie (130).
1.6.1 Since 2004 I have never encountered
a situation where any Pubco has removed the AWP tie in any supply
tied leasehold. This recommendation has been completely ignored.
1.6.2 There is substantial evidence that there
are considerable royalty payments paid by the amusement machine
operators. For example, in the published accounts of Enterprise
Inns 2007, the machine income was shown as £29 million as
opposed to 2006 £26 million. This income could only come
from royalties as Enterprise Inns do not operate a managed estate.
If a machine tie did not exist, there would be no royalty payments
and thus the on site machine rental payments to the supply tied
lessee would be considerably lower than as at present.
2. THIRD PARTY
REFERRAL
2.1 The opportunity exists in every supply
tied lease for a rent to be determined by third party referral.
This is usually to arbitration, although certain leases specifically
state that independent expert shall be the only method of dispute
resolution.
2.2 The Pubcos have a considerable advantage
in this situation in that they effectively have a bottomless cheque
book in respect of fees, whereas the supply tied tenant is the
exact opposite. I have first hand knowledge of BDMs/BRMs stating
that if arbitration is sought, the tenant will incur many thousand
pounds worth of expenditure and in every instance, the Pubco will
win and their associated costs will also be added to the costs
of the tenant. These scare tactics regrettably often have the
effect of frightening a supply tied leaseholder into not seeking
third party referral as a result of the threat of an horrendous
cost burden.
2.3 The situation is further exacerbated
by the arbitrators appointed by the RICS, a large number of whom
are Centrally London based, whose fees regularly exceed £300
an hour plus VAT. Thus for a very simple investigative progress
prior to the actual event of arbitration submissions, could involve
preliminary meetings with the arbitrator and preliminary issues
that could easily utilise 10 hours of the arbitrator's chargeable
time. Thus even before the arbitration effectively starts into
a serious mode, over £3,000 of fees have been expended.
2.4 To my personal knowledge, fear tactics
are regularly used on a cost basis by BRMs/BDMs to dissuade supply
tied licensees to even consider the standard legal remedy that
is open to them, ie third party referral. I conclude that the
above has a direct link to 1.2 above.
3. STRUCTURAL
ALTERATIONS
3.1 A significant influence within the profits
test valuation methodology for rent review purposes, is the consideration
of structural alterations undertaken by the tenant at the tenant's
expense with landlord's authorisation. Pubcos are singularly lax
in explaining the definitive regulations that exist in respect
of the establishment of evidence of structural alterations with
landlord's consent. Although the situation may exist that the
scheme of works is discussed with various levels of authority
in the Pubco, that a planning application has been approved and
that even the building surveyors of the Pubco have inspected and
authorized the works themselves by verbal consent, I have never
had a situation where the Pubco has explained in simple terms
that a formal Licence of Alteration is actually required to stabilize
the presence of the works concerned. Numerous examples exist of
this situation which include the following sample premises:
— The Charcoal Burner, Sidcup—Scottish
& Newcastle;
— The Filly Inn, Lymington—Punch
Taverns;
— The George, Braunton—Enterprise
Inns;
— The Rose & Crown, Dartford—Wellington
Pub Co.;
— The Portobello Gold, Notting Hill—Enterprise
Inns/Unique Pub Co.; and
— The Six Bells, Kidlington—Punch
Taverns.
3.2 The effect of not having a formal Licence
of Alteration initially is dismissed by the Pubco rent review
representative as evidence that the structural works should be
included in the rent review. In every instance as outlined above,
I have ensured that a retrospective Licence of Alteration has
been applied for which has been, sometimes with great reluctance,
easily approved.
3.3 This is a further example of a complete
lack of transparency and lack of good estate management which
with the ignorance of the supply tied lessee, sometimes leads
to an increased rent that under the rules of rent review and the
disregards in the rent review clause of the lease, should not
occur. I conclude that the basic principles of good Estate Management
are not being followed which has an effect on the "Transparency"
aspect of the TISC recommendations—see 1.3 above.
4. CONCLUSION
4.1 As a result of the information set out
above, I have to conclude that the voluntary recommendations of
the TISC as issued in 2004 have been completely ignored by the
Pubco operators, thereby ensuring the maximization of their rental
income to the benefit of shareholders, institutional investors
and debt funding.
22 September 2008
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